Deprecation Methods

Process of allocating the cost of a long-lived tangible asset over its useful life.

Straight-line (SL) depreciation
SL depreciation = (Original cost - Salvage value) / Depreciable life.

Double declining balance (DDB) depreciation
Accelerate the depreciation by applying a constant rate (200%) to a decling book value
Not explicitly use salvage value but halt when salvage value is reached.
One of the common accelerated depreciation

DDB depreciation = 2 x [(Original cost – Accumulated depreciation) / Depreciable life].

Sum of year’s digits (SOYD) depreciation
One of the common accelerated depreciation.

Depreciation in year i = (n-i+1) (Original cost – salvage value) / SOYD

n - remaining depreciable life
SOYD = n! = Sum [1 + 2 + …+ n ].= (n)(n+1)/2

Note:
· As most assets generate more benefits in their early years, accelerated depreciation method is more appropriate.

Units-of-production (UOP) depreciation

UOP = (Original cost - Salvage value) x (Units produced in a given period / Total units expected over depreciable life).

Hours-of-service Depreciation
· Same concept as unit of production depreciation except that the depreciation expense is a function of total hours of service used during an accounting period.

Sunking fund depreication
· A decelerated depreciation method
· Must know cash flows and IRR produced by the asset
· Prohibited in US

Depreciation in year i = cash flow in year i –(IRR x book value at beginning of year i)

Effect of inflation
Economic logic requires that depreciation be based on the current cost of assets. But in some environments, firms continue to use historical costs, which understates expense and overstates earnings.

Accelerated depreciation delays taxes payable (like interest free loan), which is positive considering time value of money.

Economic depreciation
Allowance for the replacement of all asset